Managerial Economics & Business

Strategy

Chapter 14
A Managers Guide
to Government in the
Marketplace

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Overview
I. Market Failure

Market Power
Externalities
Public Goods
Incomplete Information

II. Rent Seeking

III. Government Policy and International Markets
Quotas
Tariffs
Regulations
14-2

Market Power

Market power is the ability
of a firm to set P > MC.

Firms with market power
produce socially inefficient
output levels.
Too little output
Price exceeds MC
Deadweight loss

Deadweight
Loss
MC

PM
PC
MC

Dollar value of societys

welfare loss

QM

QC
MR

Q
14-3

Antitrust Policies

Administered by the DOJ and FTC

Goals:
To eliminate deadweight loss of monopoly and
promote social welfare.
Make it illegal for managers to pursue strategies
that foster monopoly power.

14-4

Sherman Act (1890)

Sections 1 and 2 prohibits price-fixing,
market sharing and other collusive
practices designed to monopolize, or
attempt to monopolize a market.

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United States v. Standard Oil of

New Jersey (1911)

Charged with attempting to fix prices of petroleum
products. Methods used to enhance market power:

Physical threats to shippers and other producers.

Setting up artificial companies.
Espionage and bribing tactics.
Engaging in restraint of trade.
Attempting to monopolize the oil industry.

Result 1: Standard Oil dissolved into 33 subsidiaries.

Result 2: New Supreme Court Ruling the rule of reason.
Stipulates that not all trade restraints are illegal, only those that are
unreasonable are prohibited.

Based on the Sherman Act and the rule of reason, how

do firms know a priori whether a particular pricing
strategy is illegal?
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Clayton Act (1914)

Makes hidden kickbacks (brokerage fees)
and hidden rebates illegal.

Section 3 Prohibits exclusive dealing and
tying arrangements where the effect may
be to substantially lessen competition.

14-7

Cellar-Kefauver Act (1950)

Amends Section 7 of Clayton Act.

Strengthens merger and acquisition policies.

Horizontal Merger Guidelines
Market Concentration

Herfindahl-Hirschman Index: HHI = 10,000 wi2

Industries in which the HHI exceed 1800 are
generally deemed highly concentrated.
The DOJ or FTC may, in this case, attempt to
block a merger if it would increase the HHI by
more than 100.
14-8

Regulating Monopolies:
Marginal-Cost Pricing
P

MC
PM
PC

Effective Demand

MR
QM

QC

Q
14-9

Problem 1 with Marginal-Cost

Pricing: Possibility of ATC > PC
P

MC
PM
ATC
PC

ATC

MR
QM

QC

Q
14-10

Problem 2 with Marginal-Cost

Pricing: Requires Knowledge of
MC
P
Deadweight loss
after regulation

MC

PM
Deadweight loss
prior to regulation
PReg
Effective Demand

MR
QReg QM

Q*

Shortage
14-11

Externalities

A negative externality is a cost borne by
people who neither produce nor consume
the good.

Example: Pollution
Caused by the absence of well-defined
property rights.

Government regulations may induce the

socially efficient level of output by forcing
firms to internalize pollution costs
The Clean Air Act of 1970.
14-12

Socially Efficient Equilibrium:

Internal and External Costs
P

Socially efficient equilibrium

MC external + internal

PSE

MC internal

PC
MC external

Competitive
equilibrium

D
QSE QC

14-13

Public Goods

A good that is nonrival and nonexclusionary
in consumption.
Nonrival: A good which when consumed by one
person does not preclude other people from also
consuming the good.
Example: Radio signals, national defense
Nonexclusionary: No one is excluded from
consuming the good once it is provided.
Example: Clean air

Free Rider Problem

Individuals have little incentive to buy a public good
because of their nonrival & nonexclusionary nature.
14-14

Public Goods
$

Total demand for streetlights

90

54

Individual
Consumer
Surplus

MC of streetlights

30
18

Individual demand
for streetlights
12

30

Streetlights
14-15

Incomplete Information

Participants in a market that have
incomplete information about prices,
quality, technology, or risks may be
inefficient.

The Government serves as a provider of
information to combat the inefficiencies
caused by incomplete and/or asymmetric
information.

14-16

Government Policies Designed to

Mitigate Incomplete Information

OSHA
SEC
Certification
Truth in lending
Truth in advertising
Contract enforcement

14-17

Rent Seeking

Government policies will generally benefit
some parties at the expense of others.

Lobbyists spend large sums of money in an
attempt to affect these policies.

This process is known as rent-seeking.

14-18

An Example:
Seeking Monopoly Rights

Firms monetary incentive to
P
lobby for monopoly rights: A

Consumers monetary incentive
to lobby against monopoly:
A+B.
PM

Firms incentive is smaller than
consumers incentives.
C

But, consumers incentives are P
spread among many different
individuals.

As a result, firms often succeed
in their lobbying efforts.

Consumer
Surplus
A = Monopoly Profits
B = Deadweight Loss

MC

D
MR
QM

QC

Q
14-19

Quotas and Tariffs

Quota
Limit on the number of units of a product that a foreign
competitor can bring into the country.
Reduces competition, thus resulting in higher prices, lower
consumer surplus, and higher profits for domestic firms.

Tariffs
Lump sum tariff: a fixed fee paid by foreign firms to enter
the domestic market.
Excise tariff: a per unit fee on each imported product.
Causes a shift in the MC curve by the amount of the tariff
which in turn decreases the supply of all foreign firms.

14-20

Conclusion

Market power, externalities, public goods,
and incomplete information create a
potential role for government in the
marketplace.

Governments presence creates rentseeking incentives, which may undermine
its ability to improve matters.

14-21